The Three Basel Accords

History of the Basel Norms

After the collapse of the gold standard in 1971 and the fall of the Smithsonian arrangement in 1973, many banks were concerned about the fact that banks with an international presence were not holding sufficient capital. Since the international financial system had come to be deeply integrated by this time, it became a source of great concern for the various countries involved. A crisis that was born in one country could quickly spiral out of control and affect the other countries as well.

It is for this reason that the central banks of the prominent G-10 nations created a committee of experts. This committee came to be called as the Basel Committee on Banking Supervision or simply as the Basel Committee. As per the recommendations of this committee the Basel norms were first formulated under the patronage of the Bank for International Settlements (BIS).

The banking industry has undergone drastic change in the past three to four decades. Hence, the Basel norms that were first formulated became obsolete and Basel –II norms had to be introduced. At the present moment, even the Basel-II norms seem inadequate and the major banks in the world are swiftly moving towards a new accord called the Basel-III system.

In this article, we will briefly understand what these Basel norms are and how they affect the banking industry.

The First Basel Accord

The Basel Committee has worked for multiple years and finally the first Basel accord came into existence in 1988. Originally the accord was to be binding only to the members of the G-10 group i.e. 10 countries. However, more than 190 countries volunteered to follow the norms proactively since almost every nation in the world was facing turmoil in the banking sector. The first Basel accord had two purposes. Firstly, it wanted to ensure that all the banks which have an international presence have a minimum acceptable level of capital maintained. This would ensure stability of the international system and that all the other banks are not exposed to counterparty risks. Also, it nullifies the temporary advantages that the banks can pass on to their customers when they are not required to maintain a minimum amount as capital.

However, the first Basel accord had some serious shortcomings which became evident only after the system was implemented. Firstly, the first Basel accord only focused on credit risk. The other types of risks such as operational risk were simply excluded from the analysis. Therefore, it would only partially prepare the bank in the event of a crisis. Also, the credit risk calculations failed to take into account qualitative measures like the different quality of debtors as well as the risk that are likely to pose. Also, the first Basel accord focuses on the book values of the credit exposure and not the market values. This has made the accord obsolete given the fact that newer financial instruments can create a considerable variation between the book value and the market value of the asset which is creating the credit exposure.

The Second Basel Accord

The bank of International Settlements realized that the first Basel Accord was not enough to meet the burgeoning needs of the banking sector. Hence, they created the Second Basel Accord to get rid of the shortcomings. This accord was adopted by the world in June 2004. The second accord was basically an extension of the first accord. Therefore, very few regulations that were a part of the first accord were removed. Instead multiple new additions were made and the scope of the accord was widened. The Basel accord included three pillars on which the stability of the global banking industry was dependent. These three pillars are capital controls, supervisory review and market discipline. The accord provides accurate mathematical models that need to be used by banks across the globe, thereby standardizing the process.

The second Basel accord also recognized market risk. Also, market values were often included in the calculations being made by the mathematical models. Hence, the major shortcomings of the first Basel accord were overcome by this agreement.

The Third Basel Accord

The global banking crisis that ensued worldwide in 2008 exposed the weakness of the industry. Hence, the second Basel accord was no longer seen as being adequate. Instead, regulators started clamoring for more and better rules to be introduced in order to better regulate the banks. This was the beginning of the formulation of the Basel-III norms. The third Basel accord should have ideally been implemented by now. However, there have been certain delays in the process and worldwide adoption of Basel norms is expected to occur by 2018.

The third Basel accord plans to aggressively increase the amount of money banks hold on as capital. Although, the total amount of capital required may remain unchanged, the third accord requires a considerably higher amount of tier-1 capital to be maintained. For instance, the amount of equity capital to be maintained has been increased to 4.5% from the erstwhile 2%.

Also, the third Basel accord has created the provision for capital buffers. These capital buffers will act as the second layer of protection for the banks in the event of a crisis. Provision has also been made for countercyclical buffers. These buffers will help regulate the volume of credit and prevent a credit boom from occurring so that a bubble is not formed.

To supplement all these measures, a non risk based leverage ratio will also be introduced. This ratio will limit the use of leverage by banks that have an international presence.

The Basel accords have therefore undergone a drastic change since their introduction in 1988. The third Basel accord is expected to be able to provide the banking industry with the much needed stability using which a period of growth can be ushered in.

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